2003-2004 Essay Contest

Primer: Income Inequality

What role, if any, should the government play in addressing income inequality?

Essay Contest Poster

One often hears the phrase "The rich get richer and the poor get poorer," but how true is that statement in the United States? On one hand, according to several statistics, income inequality is widening. In 1981, the total combined income earned by the wealthiest 5 percent of Americans was 6.9 times greater than the combined income earned by the poorest 20 percent. By 2001, the ratio of the wealthiest to the poorest had increased to 8.4. On the other hand, U.S. Census Bureau studies show that during that same time, poverty rates steadily decreased—from 14 percent in 1981 to 11.7 percent in 2001. It seems almost contradictory that significant inequality ratios stand next to decreasing poverty rates. Yet this contrast exemplifies the complexity of the issues regarding income inequality.

Income inequality exists in the United States, but what does that mean for our society? Perhaps income inequality is an acceptable part of a dynamic and prosperous economy, providing incentives to work hard and advance in education. Or does it disrupt social cohesion and disenfranchise the poor? In this year’s essay contest, students are asked to consider the economics of income inequality and determine what policy, if any, the government should take regarding these issues.

The Statistics Behind Income Inequality

Economists have long debated the causes of income inequality; however, it is generally agreed that educational attainment and family structure are currently two significant factors.

Over the past few decades, more jobs have required high-skilled workers. Therefore, wages for college-educated workers have increased faster than those of low-skilled workers as demand for high-skilled workers increased. This trend accelerated during the late 1990s when companies continued to rely more on technology. In 2000, individuals with college degrees were on average paid 80 percent more than those who had graduated solely from high school. Therefore, the changing nature of the American economy, with its increasingly greater emphasis on education and information, has contributed to increased income inequality.

Changes in family structure have also widened the income gap. A growing percentage of Americans live in single-parent households. These families, often headed by single-mothers, earn about half the income of two-parent families. Among the highest paid 20 percent of households, 90 percent are married-couple families; among the poorest 20 percent of households, two-thirds are single or single-parent families. This trend in household structure is a second significant factor explaining income inequality in the United States today.

Identifying the Problem

The economic concept of externality can help identify the costs and/or benefits regarding income inequality issues and help inform the role government might play, if any, in addressing income inequality. Externalities are social costs and benefits that spill over beyond the private costs and benefits faced by an individual. One classic example of an externality is a factory's smokestack that pollutes the air and causes health problems for people living nearby. The factory does not face any costs as a result of its pollution; instead, that pollution is a cost that has "spilled over" to the people nearby, who have to "pay" for its unpleasantness and toxicity. One role of government is to sometimes step in and address this form of market failure through regulations, taxes or programs—for if left alone, a market tends not to solve externalities. One way to begin looking at the essay contest question is to ask whether there are external costs or benefits to income inequality.

On one hand, some argue that there are significant external costs due to income inequality. They argue that inequality weakens social cohesion as the lives of the rich and poor become more isolated and separate. With greater inequality, the poor feel disenfranchised and do not participate in civic life, while the rich gain an increasingly powerful influence in politics—thus weakening democracy. Greater income inequality may also result in lower health and increased crime nationally. Furthermore, some contend that poverty breeds poverty, as the children of the poor have to work harder to succeed than the children of the rich. Without intervention, the problems caused by income inequality will only get worse in the future.

On the other hand, others contest the validity of these external costs and point to possible external benefits of income inequality. Many say that some of the external costs brought up in the previous paragraph— such as higher crime, lower health and less opportunity—are not effects of income inequality, but of poverty. External costs due to poverty exist (individuals in poverty are more likely to commit crime, have health troubles and have children who enter kindergarten not ready to learn), but these problems are separate from the issue of income inequality. In fact, some contend that instead of disenfranchising, income inequality provides incentives for those who are at low- to middle-income levels to work hard, attain more education and advance to better-paying jobs.

There is a great deal of contention over the external costs and benefits of income inequality. And externalities are not the only economic lens to look through when considering the issue. Often the results of income equality and inequality are discussed as a trade-off between equity and efficiency. Some argue that relatively equal levels of income may promote social cohesion, but market efficiency may be lost due to government intervention or central planning.

Once a student has determined how they view income inequality, he or she can then begin to consider what policy, if any, government should adopt to address the issue.

What to do?

Those in favor of reducing income inequality might, in their essay, describe why income inequality results in externalities or problems and propose measures government could take to remedy them. Possible policies include a more progressive tax system, increased earned income tax credits, or other such policy that redistributes income from the rich to the poor in order to decrease the income divide. Not only, they might argue, would the external costs of income inequality be removed, but poverty itself would also be reduced.

In contrast, those opposed to government involvement in income inequality might argue that externalities do not stem from income inequality, but rather from poverty. Government should therefore focus on the welfare of the poor, rather than worrying about the income gap. Policies to address the welfare of the poor might include programs that provide preventive medical care or housing subsidies—or a policy that promotes early childhood and K-12 education in order to provide greater opportunity for all.

Other papers might argue that the government should remain out of the issue completely, arguing that income inequality is not a problem to current American society—or, perhaps, that it is a natural result of our changing economy and the increasing valuation of education.

Essay writers may also, if they wish, compare income inequality in the United States with other countries. For example, the distribution of income in Germany and France is more equal than in the United States. Germany and France also have more extensive government services, like health care and unemployment benefits. However, there may be a trade-off in these benefits. While Germany and France have lower income inequality, they also have higher unemployment rates than the United States.

The ideas suggested in this primer are just a few of the ways students can think about income inequality when they research the topic and write their essays. Students are encouraged to take an innovative position as well as carefully consider the economic concepts involved. The Minneapolis Fed staff look forward to reading this year's papers.

Best of luck!

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